DAIRY INDUSTRY RESTRUCTURING ACT REVIEW

DAIRY INDUSTRY RESTRUCTURING ACT REVIEW

DAIRY INDUSTRY RESTRUCTURING ACT REVIEW Initial Submission from Westland Milk Products June 2018

DAIRY INDUSTRY RESTRUCTURING ACT REVIEW

2 Disclaimer The economic modelling and expert comments in this report have been prepared by TDB Advisory Ltd (TDB) for Westland Milk Products with care and diligence. The statements and opinions in this report are given in good faith and in the belief on reasonable grounds that such statements and opinions are correct and not misleading. However, no responsibility is accepted by Westland Milk Products, TDB or any of its officers, employees, subcontractors or agents for errors or omissions arising out of the preparation of this report, or for any consequences of reliance on its content or for discussions arising out of or associated with its preparation.

DAIRY INDUSTRY RESTRUCTURING ACT REVIEW

3 Table of contents 1. Introduction and summary ___ 4
2. Background ___ 9
3. Is DIRA achieving its objectives ___ 14
4. Regional development ___ 38
5. Environmental considerations ___ 39
6. Fonterra Co-operative Group Limited ___ 40
7. Conclusions ___ 41
Appendix 1: Calculation of Fonterra’s capital value including assumed merger benefits ___ 43
List of tables Table 1: Summary responses to MPI’s questions ___ 6
Table 2: Major farm gate competitors ___ 17
Table 3: Attributes of milk production changes since 2001 ___ 19
Table 4: Farm gate competition ___ 24
List of figures Figure 1: Milk curves – international comparison ___ 10
Figure 2: Timeline of FGMP and commodity prices ___ 15
Figure 3: Dairy processing volume in NZ ___ 16
Figure 4: Farm gate competition in 2001 and 2017 ___ 16
Figure 5: Revenue per kgMS per processing company ___ 18
Figure 6: 7-year average adjusted ROA-WACC 2011-2017 ___ 19
Figure 7: Farm gate competition ___ 24
Figure 8: Milk production by region ___ 25
Figure 9: Three channels to market in domestically-focused dairy sector .

DAIRY INDUSTRY RESTRUCTURING ACT REVIEW

4 1. Introduction and summary 1.1 Introduction Westland Milk Products (Westland) is a key economic driver of the West Coast economy and New Zealand’s second biggest dairy cooperative. Dairy is also the biggest single contributor to GDP on the West Coast and consistently contributes almost a quarter of a billion dollars annually ($234.4 million in 2016 alone.) Westland has 342 shareholding farmers and over 420 supplying farms. It employs 555 staff in total as well as indirect supplier jobs and contributes to considerable economic ‘spill overs’ to the region. During the deliberations which became the Dairy Industry Restructuring Act 2001 (DIRA), Westland chose to remain an independent processor in order to maintain processing on the West Coast.

The company believes that New Zealand needs strong independent processors that work as part of NZInc and that it is very important to counter against any global perception of New Zealand having a state-supported monopoly.

Westland agrees with our economic experts, TDB, in that the DIRA enabled Fonterra to be set up as a near monopoly / monopsony in New Zealand’s dairy markets. DIRA was designed to be the counterbalance. It included a number of provisions designed to foster competition at the farm gate and to protect New Zealand dairy product consumers. The key “contestability” provisions that apply to Fonterra are:
  • open entry;
  • open exit;
  • no discrimination between suppliers;
  • the right for Fonterra suppliers to supply up to 20 percent of their weekly production to an independent processor; and
  • the setting of the base milk price. In addition, the Dairy Industry Restructuring (Raw Milk) Regulations 2012 (DIRA regulations) require Fonterra to supply raw milk to Goodman Fielder and independent processors (IPs) subject to certain conditions.
  • DIRA was originally envisaged as temporary legislation with automatic expiry provisions once certain milk-supply thresholds were met. Those automatic expiry provisions have now been removed. The objectives of the current review by the Government are to ask:
  • is the DIRA regulatory regime operating in a way that protects the long-term interests of New Zealand dairy farmers, consumers and the nation’s overall economic, environmental and social wellbeing?
  • does the DIRA regulatory regime give rise to any unintended consequences manifesting themselves in other parts of the wider regulatory system and, if so, to what extent? and
DAIRY INDUSTRY RESTRUCTURING ACT REVIEW
does the purpose and form of the DIRA regulatory regime remain fit-for-purpose, given the dairy industry’s current structure, conduct and performance, as well as the global and domestic challenges and opportunities facing the industry, the wider regulatory system within which it operates, and the Government’s broader policy objectives? 1.2 Executive summary The DIRA contestability provisions have helped protect the long-term interests of New Zealand dairy farmers, consumers and the nation’s overall economic wellbeing. This is demonstrated by:
  • farmers have an increasing level of farm gate competition;
  • New Zealand consumers have been at least partially protected from the adverse impact of the formation of Fonterra to the extent that there is more competition in the domestic market now than there was, although in our opinion, regulatory changes are required to remove the competitive limits unintentionally imposed; and
  • the dairy industry continues to be an important contributor to New Zealand’s economic health. It is recognised that the dairy industry’s environmental impact has worsened as intensification has increased and as land has been converted to dairy. We consider that, at the margin, DIRA’s open-entry provisions have contributed to this outcome and could be phased out without imposing significant costs.
  • The poor environmental situation (and, probably more importantly, the industry’s slow and hesitant response to it) means that there is a lot of discussion now about dairy farmers having lost their social license to operate. From that perspective, we would argue that DIRA has not protected the nation’s wellbeing. However, we would argue that any environmental protections required should be imposed by generic environmental legislation rather than through DIRA. The purpose of the DIRA regulatory regime remains fit-for-purpose, although we would recommend the following changes:
  • we contend that open-entry (and open re-entry) could be phased out. To be clear, by open entry and open re-entry we mean milk from new dairy conversions. We do not mean that Fonterra could not choose to collect milk from an existing dairy farm. Open entry has contributed to the development of marginal farming land so we would be happy to have that area closed to entry. We do not want to see a situation whereby any farmer would not have their milk collected;
  • the base milk price provisions remain crucial, but we would recommend a number of changes to the milk price methodology as follows: − Fonterra’s average currency conversion rate should be excluded from the calculation, − non-Global Dairy Trade sales should be excluded from the calculation, and − the asset beta used should not be that of the hypothetical efficient processor, but that of the industry. (Note – this is a different discussion to the one that the Commerce Commission is currently consulting on.);
DAIRY INDUSTRY RESTRUCTURING ACT REVIEW
  • the special provisions relating to Goodman Fielder should be removed and Fonterra should be required to supply 100 percent of the raw milk required by any domestic dairy products market competitor; and
  • full accounting separation and reporting of Fonterra and FBNZ should be required. The recommended changes to the milk price methodology are intended to increase the transparency of the calculation. Currently, Westland believes Fonterra’s prices appear to be unacceptably manipulated. With regard to the domestic market, the highly seasonal nature of the milk production in New Zealand, relative to the pattern of domestic demand, and the absence of a factory gate market mean that domestic competitors are largely reliant on Fonterra for their milk supply. The raw-milk supply provisions, therefore, essentially limit the size of domestic competitors by limiting their access to 50M litres of milk (or 250M litres in the case of Goodman Fielder (GF)). We consider that the individual company limits should be removed and all potential suppliers to the domestic market be treated equally in terms of their access to Fonterra milk. Full accounting separation and reporting of Fonterra and FBNZ is required to ensure that FBNZ’s ability to compete in the domestic market is not being subsidised by another part of the business.
  • Westland believes that there are some unintended outcomes from the DIRA such as the dominant player mentality displayed by Fonterra. We want measures in place that prevent discriminatory behaviour. For this we see a need for the legislation to potentially be strengthened in a way that prevents abuse of market power and the maintenance and encouragement of true contestability. Table 1: Summary responses to MPI’s questions Question Summary response 1. Benefits of 2001 industry restructure realised?
  • There is little evidence that Fonterra has delivered the anticipated benefits to farmer/shareholders
  • The anticipated benefits for farmer/shareholders were $310 million per annum
  • We estimate that those benefits should translate into a theoretical share price now of $8.43 versus the current actual price of $5.15
  • We estimate that, in the absence of those benefits, the theoretical share price now should be $6.07 2. Is the DIRA contestability regime contributing to and/or impeding the sector’s performance?
  • Leaving aside the original mega-merger, performance and competition within the dairy sector has not been impeded by DIRA
  • Fonterra’s farm gate market share has decreased by 14 percent in 16 years – from 96 percent to 82 percent
  • Five new IPs have started up since Fonterra was established, with one of those failing. An additional two new IPs have announced their intention to build new processing plants. Along with Westland and Tatua, the addition of the two new companies would bring the total number of IPs competing with Fonterra at the farm gate to eight
  • The organisational structures of IPs range from co-operative companies to private companies to publicly listed companies
  • The strategies employed by the IPs range from commodity to business-to-business to consumer products
  • We estimate that capital of approximately $19 billion has been invested by the processors since 2001 3. Who is benefiting?
  • Farmers – the amount of on-farm investment since 2001 indicates that farmers have been earning an adequate return on their investment
  • Processing company shareholders – the return on asset performance of the IPs vis-à-vis their capital cost is variable
  • NZ Inc – the contribution of the sector to the NZ economy continues to be significant
  • However, it is generally accepted that the environment has suffered as a consequence of dairying. It could be argued that DIRA has contributed to that outcome 4. What incentives exist for the dairy industry to transition to higher value products?
  • There isn’t any incentive but neither is there any disincentive
  • Moving up the value chain brings potential for higher investment returns
  • Moving up the value chain also increases risk
  • The challenge for companies is to create value rather than to necessarily move up the value chain
  • The Government’s role is to create an environment that allows the processors and their shareholders to make their own decisions about their business strategy and how much risk they want to take 5. Are the current contestability provisions still fit-for-purpose?
  • The incentives and ability for Fonterra to operate to the detriment of the long-term dynamic efficiency of the broader dairy industry remain and, with stalled milk growth, might be stronger now than they were in 2001
  • There is more competition at the farm gate now than there was in 2001 and there have been a number of announcements since the last Commerce Commission review regarding increasing competition at the farm gate
  • There is more domestic consumer market competition now than there was in 2001, although there are a number of unintended consequences with respect to the raw-milk supply provisions
  • No factory gate market has developed 6. What changes are required?
  • 7. Are changes to the industry and/or the DIRA regulatory regime required?
  • The open-entry provision is no longer required
  • The base milk price provision is still required but changes are needed to make the calculation of the FGMP more transparent
  • Fonterra’s obligation to supply raw milk destined for the domestic market to competitors should not be capped 8. Is the domestically-focused dairy sector operating in the long-term interests of New Zealand consumers?
  • The domestic market is still dominated by the same two companies (although one has a different owner – GF)
  • In the grocery channel, we estimate that Fonterra and GF’s combined market share has decreased by 8 percent (from approximately 95 percent to 87 percent) since 2001
  • The milk-supply volume limits do not restrict the number of domestic competitors that could emerge but do unnecessarily limit the absolute and relative size of any of those competitors in an environment of domestic market growth 9. Are there significant economies of scale in the collection, processing, and wholesale distribution of into domestic consumer markets?
  • Yes – in two areas – collection costs and capacity costs
  • The domestic market requires a flat milk curve supplying constant monthly milk volumes
  • The NZ milk-production curve is not flat. There is twenty times more milk produced in the peak month than there is in the low month
  • We estimate that 10 to 15 percent of Fonterra suppliers supply winter milk
  • A larger proportion would require the processor to either pay higher winter-milk premiums than Fonterra or to travel further to collect milk
  • A larger proportion would require the processor to hold more capacity in reserve to manage daily demand fluctuations 10. What would the domestically-focused dairy sector look like in the absence of the DIRA regulations?
  • The absence of DIRA regulations would lead to fewer competitors and higher prices for domestic consumers as per the Commerce Commission’s 2016 report 11. Does the DIRA regulatory objective of ensuring “competition in the wholesale supply of domestic consumer dairy products” remain fit-forpurpose?
  • Yes – the regulatory objective remains fit-for-purpose, although changes to the regulations are required to remove the disincentive that potential domestic competitors have to invest, and to remove the regulatory limits on the size of individual competitors 12. What changes would be required to ensure that the DIRA regulatory regime supports a well-functioning domestically-focused dairy sector that operates in the long-term interests of New Zealand consumers?
  • Fonterra’s obligation to supply raw milk destined for the domestic market to competitors should be unlimited
  • That obligation needs to be on-going and needs to survive any future phasing out of the other contestability provisions
  • Fonterra should be obliged to separately account for and report on its domestic consumer brands business ‘Fonterra Brands New Zealand’, to demonstrate that its financial performance is not being subsidised by some other part of the business

9 2. Background 2.1 Context Total global annual milk production is estimated to be around 500 billion (B) litres of milk1 .

The size of the internationally traded dairy-products market is estimated to be the equivalent of around 65B litres, or around 15 percent of total production. New Zealand’s annual milk production is estimated to be approximately 21B litres (or less than 5 percent of global production), of which, approximately 5 percent is consumed domestically and 95 percent is exported. New Zealand’s share of the internationally traded dairy-products market is approximately 30 percent, or 20B litres p.a.

While being able to produce huge volumes at internationally competitive prices is positive, there are aspects of the New Zealand industry that are very challenging, including the proportion of production that needs to be exported, the consequent exposure to international prices, the distance from export markets and the shape of the seasonal milk curve. The New Zealand dairy industry is internationally cost-competitive, in part because New Zealand’s temperate climate and abundant water allows the farming system to be a pasture-based system where milk production matches grass growth. The pasture-based system, however, means milk production is highly seasonal, with milk production in the peak month (October each year) being typically 20 times as large as milk production in the slowest month (June each year).

Given the seasonal milk curve and the non-seasonal nature of domestic demand, it is no surprise that the original two large pre-Fonterra domestic businesses were subsidiaries of very large export businesses (NZ Co-operative Dairy Group Ltd (NZDG) and Kiwi Co-operative Dairies Ltd (Kiwi)). Both NZDG and Kiwi had large ingredient businesses to funnel their excess milk through to manufacture and export as long-life products (through the New Zealand Dairy Board at the time). As Figure 1, below, illustrates, the shape of the seasonal milk curve in New Zealand is much more extreme than in the US or EU.

1 USDA, Dairy: World Markets and Trade, December 2016.

10 Figure 1: Milk curves – international comparison These peak to trough variations graphically illustrate the difficulty the New Zealand milk curve causes New Zealand processors, especially those who are focused on the domestic market. 2.2 Historical development of DIRA New Zealand’s largest dairy processor, the co-operative company Fonterra, was established in 2001 from an amalgamation of the then two largest dairy co-operatives: NZDG and the New Zealand Dairy Board. In forming Fonterra, participants sought to realise efficiencies of scale and scope in the collection and processing of farmers’ milk, so as to better compete in international dairy markets, for the overall benefit of New Zealand.

At the time, the value of the benefits of the mega-merger (ie, Fonterra) to New Zealand farmers was estimated to be $310M2 p.a., or almost $2.5 billion (B) on a capitalised present value basis3 . On creation, Fonterra collected approximately 96 percent of New Zealand’s raw-milk production. Allowing the creation of such a dominant firm had competition policy implications. In particular, a dominant firm could have:
  • the incentives and ability to create barriers to farmers switching to potential competitors;
  • the incentives and ability to impede entry into the farm gate market by new dairy processors; 2 “The Quigley report on dairy megamerger”, 24 January 2001. Section 4.1 of the Quigley report refers to the“Business Case for Global Dairy Co Ltd: Executive Summary”that outlines the sources of the $310M in benefits that were claimed to be associated with the merger.

3 Using Fonterra’s FY16 pre-tax WACC of 7.9% to capitalise a benefit expressed in 2001 dollar values.

  • the incentives and ability to set wholesale prices in downstream domestic dairy markets; and
  • fewer incentives to drive cost efficiencies and invest in innovation, as it could use its market position to retain farmer suppliers even if they were dissatisfied with the company’s performance. The Dairy Industry Restructuring Act, 2001 (DIRA) authorised the amalgamation and allowed it to bypass the Commerce Commission. The Commerce Commission’s earlier draft determination found that the merger would result in a strengthening of a dominant position in each of the relevant markets4 .

As the amalgamation resulted in an entity with a substantial degree of market power in several New Zealand dairy markets, DIRA was designed and implemented to mitigate the risks of Fonterra's market power. In particular, DIRA seeks to promote contestability in the New Zealand raw-milk market and provides for access for other dairy goods or services supplied by Fonterra to be regulated, if necessary. Regulations made under the Dairy Industry Restructuring (Raw Milk) Regulations, 2001 (and as amended and re-enacted in 2012) contain further provisions to facilitate the entrance of independent processors (IPs) to New Zealand dairy markets and enable them to obtain the raw milk necessary to compete in dairy markets.

The original regulations required Fonterra to supply, at a DIRA price, up to 50M litres of raw milk p.a. to any IP and up to 250M litres p.a. to Goodman Fielder (GF). The price of this regulated raw milk was the farm-gate base milk price (FGMP)5 for that season, plus reasonable transport costs. An IP, in DIRA:
  • is defined as a processor of milk, milk solids or dairy products that is not associated with Fonterra; and
  • includes GF and any associated person of that company, other than Fonterra. IPs, therefore, include the obvious companies such as Tatua and Westland, but also the less obvious companies like GF and Cadbury6 . The latter IPs outsource their raw-milk supply to vertically integrated dairy processors, rather than sourcing it directly from farmers. The default price specified in the regulations is a calculated price that is meant to ensure the following outcomes:
  • Fonterra is constrained from offering farmers a higher price for their milk. This reduces the risk of Fonterra being able to offer a higher FGMP to limit the ability of competing processors to persuade farmers to switch to supplying them; and 4 The Commerce Commission had reached the preliminary conclusion, in 1999, that the merger that formed Fonterra could not be authorised under the Commerce Act. The Commission’s preliminary estimate was that the merger would result in a price rise in domestic dairy-products markets (other than spreads) of between 10% and 20%. This translates to a wealth transfer from domestic consumers to the merged entity (Fonterra) of between $75M and $146M p.a., and a net deadweight welfare loss in the domestic dairy production and supply markets of up to $4M p.a. This deadweight loss included both allocative losses in the domestic dairy products-market and dynamic efficiency concerns.

5 The FGMP is a notional calculation of the cost of milk supplied to Fonterra on the basis that Fonterra is an efficient processor. 6 Supermarkets do not meet the definition of an IP under DIRA and do not have any direct access to DIRA milk.

  • from a domestic consumer perspective, competition in the domestic market between wholesale companies is sufficient to ensure that Fonterra does not have the power to charge prices in excess of what is required to generate an adequate return on capital employed. Thus, the DIRA contestability provisions were designed to ensure that milk flows to the highest-value user (whether the user is a producer of dairy commodities, ingredients or fresh consumer products) and to avoid wealth transfers from domestic consumers to Fonterra. The provisions work in parallel with, and are supplementary to, the general competition provisions of the Commerce Act, 1986. 2.3 Changes to DIRA Regulations in 2012 The 2001 Regulations were revoked on 1 June 2013 and replaced by the Dairy Industry Restructuring (Raw Milk) Regulations, 2012 (“the 2012 Regulations”).
  • Under subpart 1 of the 2012 Regulations:
  • the total amount of raw milk to be supplied by Fonterra to IPs increased from 600M litres per season to 795M litres per season;
  • the total amount of raw milk to be supplied by Fonterra to GF was unchanged, at 250M litres per season, but supply in the non-winter months was limited to 110 percent of the amount of raw milk supplied in the preceding October;
  • the total amount of raw milk to be supplied by Fonterra to any one individual IP was unchanged, at 50M litres per season, but maximum monthly limits for non-winter milk were put in place; and
  • the obligation on Fonterra to supply raw milk to an IP in a season beginning on or after 1 June 2016 was extinguished if that IP’s own supply of raw milk in the three previous seasons was 30M litres or more.
  • Subpart 3 of the 2012 Regulations divided IPs into two categories:
  • those with no, or less than 30M litres of own-supply raw milk; and
  • those with more than 30M litres of own-supply raw milk and those that do not require a fixed quarterly raw-milk price from Fonterra and GF. For the first group, the new regulations changed the price of raw milk supplied by Fonterra from the FGMP plus $0.10 per kilogram of milk solids (plus transport costs and winter-milk premiums) to a fixed quarterly price being Fonterra’s most recent forecast FGMP (plus transport costs and winter-milk premiums).

For the second group, the new regulations changed the price of raw milk supplied by Fonterra from the FGMP plus $0.10 per kilogram of milk solids (plus transport costs and winter-milk premiums) to the FGMP (plus transport costs and winter-milk premiums).

13 2.4 The Dairy Industry Restructuring Amendment Bill, 2017 In March 2017, as a consequence of the recommendations made by the Commerce Commission and a subsequent MPI-led review, the then-Minister introduced into the House the Dairy Industry Restructuring Amendment Bill. That Bill was subsequently substantially altered by the new Government before being passed into law on February 15, 2018.

The changes made to the DIRA by the amendment prevent the relevant DIRA provisions from expiring in the South Island and remove the market share thresholds that would trigger the Act’s expiration in the future. The other provisions that were set out by the original Bill (under the previous Government) were removed7 .

In removing the previous provisions which timetabled a further review for 2020/21, the new Government announced its intention to “undertake a comprehensive review of the DIRA and consult fully with the dairy sector”8 , commencing in 2018. 7 The original Bill (among other things): − removed the default expiry provisions and the market share thresholds in the North and South Islands that trigger a review of the state of competition; − required a review of the state of competition to commence during the 2020/21 dairy season; − required a review at five-year intervals thereafter if competition has not yet been considered sufficient; − allowed Fonterra the discretion to refuse supply from new dairy conversions; − reduced the total volume of raw milk that Fonterra must supply to IPs from 795M litres to 600M litres per season; and − removed the requirement for Fonterra to supply DIRA milk to large export-focused processors from the beginning of the 2019/20 season.

The definition of a large export-focused processor was one that has the capacity to process more than 100M litres of milk per season and exports more than 50% of its production by volume. 8 https://www.beehive.govt.nz/release/dairy-industry-restructuring-amendmentbill-passed

14 3. Is DIRA achieving its objectives 3.1 Introduction There are two components to the question ‘is DIRA achieving its objectives?’:
  • have the originally anticipated benefits been realised?; and
  • has DIRA enabled competition to emerge? These two questions are answered in turn below. 3.2 To what extent have the anticipated benefits of the 2001 industry restructure been realised? As noted in section 2.2, above, the anticipated benefits of the establishment of Fonterra were $310 million per annum9 . The sources of the benefits were anticipated to be as follows:
  • annual cost savings in the order of $120 million as a consequence of the elimination of duplicated facilities and activities;
  • annual revenue enhancements and productivity improvements in the order of $70 million as a consequence of enhanced economies of scale and scope if manufacturing activities are integrated with marketing and distribution functions; and
  • additional increased earnings of $120 million per year as a consequence of being able to harness the synergies between different parts of the industry, provide fresh strategic impetus and broaden options to exploit new market, technology and biotech opportunities. We would expect to be able to measure the realisation of the benefits with reference to Fonterra’s share price as follows (details of the calculations are provided in Appendix 1):
  • the expected benefit in 2001 was $310m per year to farmer-shareholders. If we assume that the expected benefit was expressed in pre-tax terms, it would equate to $223m after tax;
  • if we assume an average cost of equity for Fonterra of 9 percent, an average dividend ratio of 70 percent, and add all the new equity associated with increased production, we estimate that the current share price should be $8.43;
  • Fonterra’s current share price is $5.15;
  • if we exclude the anticipated benefit from the theoretical share price calculation, the current share price should be $6.07; and
  • we note that since Fonterra’s change in capital structure in 2012, its share price has averaged $6.10 with a range of $4.60 to $8.08. We also note that over the same period of time, Fonterra’s normalised EBITDA has increased by 0.6 percent, year-on-year10 .

9 Refer to footnote 2 above. 10 ANZ Research, Agri Focus – we have lift off, June 2018, p.24.

15 The logic employed above would lead us to conclude that there is little evidence that Fonterra has delivered the anticipated benefits to farmer / shareholders. However, it should be noted that Fonterra, like most companies, has been subject to some adverse shocks over the period (like the GFC and WPC80 crisis) that will have affected its financial performance. We do not think that it could be argued that the benefit has been passed through to shareholders via the FGMP.

In the first instance, the anticipated benefits can only be achievable as a consequence of the merger and not otherwise. We can observe that most of the IPs are paying slightly more than the FGMP to their suppliers for their milk on average and are earning more than their required rate of return, which implies that the merger was not required for any benefits to be received via the FGMP. In addition, Figure 2, below, indicates that the FGMP has generally been consistent with international commodity prices.

Figure 2: Timeline of FGMP and commodity prices Similarly Westland does not think it can be argued that the costs imposed on Fonterra by DIRA have therefore been excessive. The contestability provision that has received the most attention by Fonterra (and has subsequently been changed most significantly as a consequence) is the raw-milk supply provision. We estimate that the opportunity cost to Fonterra of having to sell raw milk to IPs at the FGMP has been approximately $25-$30 million per annum. DIRA, by allowing the mega-merger to be formed without going through the normal Commerce Commission process, was a major step.

DIRA itself was an attempt to offset the adverse competition effects of the merger. DIRA has been reasonably successful in this regard. Figure 3, below, presents a time series of dairy processing volumes in New Zealand since 1983.

16 Figure 3: Dairy processing volume in NZ 3.3 To what extent and in what way is the DIRA contestability regime contributing to or impeding the sector's performance? Figure 3 shows no notable change in the trend in New Zealand’s milk production following Fonterra’s creation (although New Zealand has likely now reached (or passed) peak cow numbers, which will see continuing growth in milk production stall or at least slow considerably from now on). In our opinion, this overall trend indicates that DIRA has not impeded industry growth.

3.3.1 Farm gate competition As presented in Figure 4, in addition to volume growth in the industry, the market share of competition at the farm gate has increased from 4 percent to 18 percent over the last 16 years.

Figure 4: Farm gate competition in 2001 and 2017 In 2001, directly following the formation of Fonterra, there were three processors competing at the farm gate in the New Zealand dairy industry with Fonterra being almost completely dominant, processing 96

17 percent of all volume collected. Since then, although Fonterra’s collection volumes have continued to grow, its market share (in terms of New Zealand milk collected) has fallen to 82 percent. The market share that has been captured from Fonterra has been distributed across multiple competitors in the farm gate market that have varying corporate structures and strategic objectives. Apart from Fonterra there are now six IPs competing at the farm gate and collecting 18 percent of New Zealand’s raw milk. An additional two IPs have announced their intentions to build new processing plants in the near future (subject to milk supply).

3.3.2 Industry composition Table 2 presents an overview of the major competitors at the farm gate (based on publicly available information). The table notes when each company was established, their total revenues in the 2017 financial year, their revenues per kgMS (which indicates where in the value chain they compete), their product positioning and their ownership structure. Table 2: Major farm gate competitors In 2001, the three competitors in the processing sector (Fonterra, Westland and Tatua), were all cooperative companies. Since 2001, new processing firms have emerged with differing corporate structures.

OCD is a public unlisted company. Synlait is publicly listed on the NZX and the ASX. Oceania is a wholly owned subsidiary of a major foreign company.

The nature of each processing business has also varied, with some processors like OCD continuing to be focused on commodity processing for the export market, other new entrants focusing on the ingredients and consumer business segments and incumbent competitors diversifying away from commodity processing into ingredients and consumer segments.

18 Our conclusion is that DIRA has contributed to increasing competition at the farm gate without placing significant structural constraints around the way in which that competition has emerged. Figure 5 presents the 2017 firm revenue per kgMS.

Figure 5: Revenue per kgMS per processing company Figure 5 highlights the variation in strategy and market positioning in the industry. Revenue per kgMS gives insight into the product mix, as it gives both an indication of sale price of products per unit of milk processed and the cost of production. The pure commodity value calculated for the hypothetical efficient processor (HEP) used for the calculation of the FGMP was $8.13 for the 2017 season. OCD (as noted above) is close to a commodity processor and only competes in the export market. Its revenue per kgMS of $8.73 is close to that of the notional processor.

Revenue per kgMS increases with Fonterra, Synlait and Westland as, in addition to commodity products, they also compete in the ingredients and the consumer markets, both domestically and internationally. A2 Milk is a consumer company and outsources its processing. Tatua is a processor of speciality ingredients and has the highest level of revenue per kgMS processed (and the highest cost of production).

Figure 5 shows that the sector in general is now made up of a diverse array of corporate strategies and that DIRA has contributed to increasing competition at the farm gate, without placing structural constraints around the way in which that competition has emerged. 3.4 Where and by whom are the benefits of the sector’s performance being captured and the costs / risks incurred? We would expect to see the benefits and the costs of the sector’s performance being captured by farmers, by the processing companies’ shareholders and the broader economy generally. We think that leaving aside how the market may have evolved in the absence of DIRA, the cost to the broader economy has been largely environmental.

19 3.4.1 Farmers Total milk production in New Zealand has increased by 60 percent since Fonterra was established in 2001. Part of that increase in production has been the result of improving genetics (animals and pasture) and farmers investing in more intensive, higher cost farming systems leading to higher production per hectare. The other part of the increase has been the result of farmers converting more land to dairy. Table 3: Attributes of milk production changes since 2001 Source: New Zealand Dairy Statistics 2016-17, LIC - DairyNZ Table 3, above, records the breakdown of the changes in milk production on-farm since 2001.

We conclude that the continuing investment by farmers in both productivity improvements and land suggests that farmers have been earning an adequate return on their capital for the risks being taken. 3.4.2 Processing company shareholders While on-farm investment by farmers seems to indicate that farmers believe that they are being adequately rewarded for the risks they are facing, it is not at all clear that the same can be said for the milk-processing companies’ shareholders. We have measured the investment performance of Westland, Fonterra, Synlait, OCD and Tatua by subtracting their weighted average cost of capital from their return on assets to see which companies have generated an adequate return and which haven’t.

We have used the FGMP to adjust each company’s reported earnings to make their relative performances comparable. Figure 6: 7-year average adjusted ROA-WACC 2011-2017

20 Figure 6 indicates that both Westland’s and Fonterra’s capital providers (and therefore shareholders) have not received an adequate return on capital employed, while Synlait’s, OCD’s, and Tatua’s have11 . We have not analysed the causes of any under or over-performance, although it is unlikely that DIRA was a major factor in the differing returns. 3.4.3 Macro economy According to the New Zealand Institute of Economic Research, from a macro-economic perspective, it is estimated that the dairy sector12 :
  • contributes $7.8 billion (3.5 percent) to New Zealand’s total GDP, comprising dairy farming ($5.96 billion) and dairy processing ($1.88 billion);
  • supports rural New Zealand, with the sector accounting for 14.8 percent of Southland’s economy, 11.5 percent of the West Coast, 10.9 percent of the Waikato, 8.0 percent of Taranaki and 6.0 percent of Northland;
  • remains New Zealand's largest goods export sector, at $13.6 billion in the year to March 2016. Export growth has averaged 7.2 percent per year, over the past 26 years, faster than any primary industry apart from the wine and ‘wood and wood products’ industries;
  • exports twice as much as the meat sector, almost four times as much as the ‘wood and wood products’ sector and nine times as much as the wine sector;
  • accounts for more than one in four goods export dollars coming into New Zealand;
  • employs over 40,000 workers, with dairy employment growing more than twice as fast as total jobs, at an average of 3.7 percent per year since 2000;
  • creates jobs at a faster rate than the rest of the economy in all but 5 territorial authorities across New Zealand;
  • provides over 1 in 5 jobs in three territorial authority economies (Waimate, Otorohanga, Southland); and over 1 in 10 in a further eight (Matamata-Piako, South Taranaki, Hauraki, Waipa, South Waikato, Clutha and Kaipara);
  • delivered $2.4 billion in wages to farmers and processing workers in 2016;
  • supports a range of supplying industries; in 2016, farmers spent $711 million on fertilisers and agro chemicals, $393 million on forage crops and bought over $190 million of agricultural equipment. Farmers also spent $914 million on agricultural services, $432 million on financial services and $197 million on accounting and tax services; and
  • as well as taking farmers’ raw milk, the dairy processing sector also spends significant amounts on packaging ($288 million in 2016), hired equipment ($199 million) and plastics ($174 million). 11 This measure is a proxy shareholder measure because the companies’ assets are funded via both debt and equity but it is a reasonable measure.

12 “Dairy trade’s economic contribution to New Zealand”, NZIER report to DCANZ, February 2017.

21 3.4.4 Environment It is generally accepted that the environment has suffered as a consequence of the performance of the dairy industry. From the dairy industry’s perspective, and leaving aside the behaviour of individual participants, it has been operating to applicable laws and regulations and they have been tightened as their inadequacies have been revealed. It might be reasonably argued that DIRA has contributed to poor environmental outcomes by incentivising the conversion of land to dairy that probably should not have been and otherwise probably would not have been converted.

An obvious example would be the Mackenzie Country land. The openentry provisions require Fonterra to accept all the milk that farmers want to supply. This means that farmers could have converted cheap (and therefore, by definition, marginal) land into dairy if it was economical to do so, knowing that Fonterra would have to collect the milk. This point is expanded upon in section 5.

3.5 What and how strong are the existing incentives and disincentives for the dairy industry to transition to a higher-value based dairy production and processing industry, that global consumers seek out, for a premium? In our opinion, the challenge for dairy companies (like other companies in the economy) is not necessarily to move up the value chain, but to create value. Creating value is not necessarily the same as moving up the value chain. Economic value is created if the return earned on the capital employed is greater than the cost of the capital employed. From that perspective, if we refer back to Figure 6, above, we can observe that Synlait, OCD, and Tatua have created value, on average, over the last seven years and Fonterra and Westland have not.

The cost of the capital employed is lowest when companies operate at the low-risk end of the risk spectrum, which means that the required return on the capital employed to compensate for this cost is also lowest at that point. For milk processing companies, the low-risk end is the commodity-production end because the margin earned by the processors is relatively constant, as the processors are able to pass the majority of the commodity=price risk back to the farmer suppliers. Risk increases as a company moves up the value chain because:
  • production is more capital intensive;
  • production is more difficult;
  • the margin earned becomes more variable, as increases in milk prices take time to be passed through to the consumer, while the consumer expects immediate relief when milk prices decrease;
  • stock becomes obsolete as tastes change; and
  • there is a constant need to invest in research and development. OCD is the closest example there is in New Zealand to a commodity product manufacturer (ie, a company at the low end of the value chain) and it has successfully created value. Tatua is probably the company that has positioned itself furthest away from the commodity end and therefore is probably

22 the riskiest of the processors and it similarly has successfully created value. Synlait is somewhere between the two in terms of risk and it has created value. Fonterra and Westland are probably similar to Synlait in terms of overall average position on the value chain, but they have lost value, on average, over the last seven years. In other words, moving up the value chain involves taking more risk and there is no guarantee that it will add value for shareholders, or the economy. Rather than seeking to promote so-called “high value” or “low value” products, the government’s role is to create an environment that allows dairy companies to adopt the strategies that best meets their objectives, manages their risks and makes the best risk-adjusted return possible for their suppliers/shareholders.

The current regulations, appropriately, do not appear to provide any strong incentive or disincentive for companies to move up or down the value chain. 3.6 Does the DIRA regulatory objective of ensuring “contestability for the supply of milk from farmers” remain fit-for-purpose? 3.6.1 Incentives The key competition concern with a company such as Fonterra having such a dominant position in the market for farmers’ raw milk is that it could have the incentive and ability to operate to the detriment of the long-term dynamic efficiency of the broader dairy industry. By declining applications for new supply, paying inefficiently high milk prices to existing suppliers and retaining the value of the exiting supplier’s capital contributions for as long as possible after they ceased to supply milk, it could “lock in” its suppliers.

Such actions would create significant barriers to entry for those seeking to compete for farmers’ raw milk and allow Fonterra to operate inefficiently, but nevertheless remain in business. To address this concern, the DIRA requires Fonterra to operate an open entry and exit regime. This means that Fonterra must accept all milk-supply offers from dairy farmers in New Zealand and allow relatively costless exit from the co-operative, upon the request of farmer-shareholders. These requirements ensure that Fonterra cannot “lock in” its farmer-suppliers, and, as a consequence, Fonterra faces strong commercial incentives to pay efficient prices for farmers’ raw milk and the capital invested in Fonterra.

The Commerce Commission reviewed the state of competition in New Zealand dairy markets and released its final report in March 2016. The Commission concluded at that time there was not sufficient competition at either the farm gate or the factory gate to consider full deregulation. Since the last Commerce Commission review, there have been a number of additional processing capacity investment or announcements by the competing processors:
  • OCD has built a new processing plant in Horotiu (Waikato) with milk processing due to commence for the 2018/19 season;
  • Mataura Valley Milk has built a new plant in McNab (Gore, Southland) with milk processing due to commence for the 2018/19 season;
  • Oceania (Glenavy, South Canterbury) intends to increase its capacity by 50 percent, although the timing of this expansion is not clear;
  • Synlait has announced the purchase of land to build a second processing plant – to be located in Pokeno (north Waikato). The plan is for this plant to be processing milk for the 2019/20 season; and
  • Happy Valley Milk has announced the construction of a new plant to be built in Otorohanga. The company has received land use consent and the plant could be ready for the 2020/21 milk season. It is not clear exactly how much additional capacity is implied by these announcements, but we estimate that it could be around 1 billion litres of milk, which equates to approximately 4.5 percent of New Zealand’s total milk production.

We are not suggesting that this additional capacity necessarily represents sufficient additional competition such that the Commerce Commission might conclude differently to what it did in March 2016. However, on the assumption that there isn’t any increase in milk production in the next three years and, in order for these plants to be full, Fonterra is most at risk of losing milk supply. To the absence of (particularly) the base milk price contestability provisions, Fonterra would have a strong incentive to transfer profits into the FGMP in order to retain milk. The Fonterra shareholders who would be most affected by such a transfer would be the 12 percent of shareholders who are not also suppliers.

Shareholder-suppliers are not affected at all by this transfer because, in total, they would still receive the same amount of cash from Fonterra with the increase in milk price, offsetting a decrease in the dividend.

We note that the milk-price principles in Annexure 1 of Fonterra’s constitution require the milk price to be the maximum it can be. 3.6.2 Farm gate competition Table 4, below, is our estimate of where there is farm gate competition in New Zealand. The points to note are:
  • there are two regions where there are more than one IP competing with Fonterra at the farm gate – the two biggest producing regions in New Zealand: Waikato and Canterbury;
  • 5 of the 11 regions have no direct competition at the farm gate (including West Coast, where Westland is currently the only processor); and
  • while there is direct farm gate competition in the regions where 74 percent of New Zealand’s milk is produced, the current capacity of the IPs limits their immediate competition to approximately one quarter13 of that milk.

13 18% / 74% = 24%.

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